A2A SpA, Italy's utility giant, just announced stellar Q1 2024 results, leaving analysts buzzing with excitement. Hydro production is roaring back, the market business is outperforming, and the company confidently raised its guidance. Everything seems rosy in A2A's garden. But beneath the surface, a potential ticking time bomb could be set to explode in 2025.

Let's dissect the situation. A2A's hydro production is predicted to hit a robust 4.4 TWh in 2024, a significant jump from the conservative 3.7 TWh projected in their initial budget. Full catchment basins and abundant snowpack are fueling this optimism. This hydro resurgence, coupled with strong market margins, explains A2A's confidence in boosting their EBITDA guidance by a whopping €100 million.

However, this exuberant reliance on hydro power might be masking a critical vulnerability for 2025. Remember 2022, the year Italy was gripped by a severe drought? The impact of that drought resonated into 2023, dragging down average hydro production figures. A2A, adhering to their 10-year average calculation for hydro power in their business plan, now projects a significantly lower 3.9 TWh for both 2025 and 2026.

This projection raises a red flag. A2A acknowledges that their hydro plants have the potential to generate up to 5 TWh in a good year. If 2024 continues its trajectory of plentiful rainfall and snow, water reservoirs will likely be full heading into 2025. Shouldn't this result in a higher hydro production estimate, exceeding the conservative 3.9 TWh figure?

Here's where the potential time bomb comes in. A2A has hedged only 20% of their 2025 hydro production at a price of €128 per MWh. This hedging strategy, while sensible in a volatile market, could backfire spectacularly if hydro production surpasses the 3.9 TWh forecast. They would be forced to sell the excess power at potentially much lower market prices, severely impacting their 2025 revenue.

Potential 2025 Hydro Revenue Shortfall

The following chart illustrates the potential revenue shortfall A2A could face in 2025 if hydro production exceeds their forecast and market prices fall.

To understand the potential magnitude of this impact, let's crunch some numbers. Assuming a conservative surplus of 0.5 TWh (500,000 MWh) in 2025, and a hypothetical market price of €80 per MWh (significantly lower than their hedged price), A2A could face a revenue shortfall of €24 million (€48/MWh price difference x 500,000 MWh). This might seem like a drop in the bucket for a company projecting €650-670 million in net income. But it represents a 3.7% dent in their projected profit, a figure that could easily escalate if the 2025 market price dips further or hydro production exceeds expectations.

The situation gets even more intriguing when we consider A2A's forward spark spread for 2024. They've hedged 30% of their CCGT production at a modest €20 per MWh. This indicates A2A's anticipation of lower gas prices in 2024, potentially driving down electricity prices and subsequently impacting spark spreads. Could this anticipated lower price environment in 2024 further exacerbate their 2025 hydro revenue risk?

While A2A boasts of its successful "flexibility" strategy, relying on CCGT plants to capitalize on peak hour margins, this approach might be insufficient to offset a substantial hydro revenue shortfall.

A2A's disposal plans to fund their acquisition of ENEL's electricity network adds another layer of complexity. They've been tight-lipped about the specific assets they're considering. However, recent Reuters reports hint at a minority stake sale in their gas distribution business. Could this disposal strategy, if executed poorly, further jeopardize their 2025 earnings by sacrificing a stable and lucrative asset?

The Lombardy region's call for bids concerning hydroelectric services, instead of launching a full-fledged tender process for expiring concessions, adds a further element of uncertainty. While A2A downplays this, stating they're prepared for any scenario, the potential loss of these concessions would undoubtedly impact their long-term hydro production capacity.

A2A is currently riding high on a wave of hydro-fueled optimism. But their conservative 2025 hydro production forecast, coupled with their limited hedging strategy, could expose them to a significant revenue shortfall. While their overall financial health appears robust, this potential 2025 time bomb warrants close attention. As investors, we must look beyond the dazzling headlines and scrutinize the underlying assumptions driving A2A's projections. Could this Italian utility giant be inadvertently setting itself up for a 2025 stumble? Only time will tell.

"Fun Fact: Italy is the second largest producer of hydroelectric power in Europe, trailing only Norway. The abundance of mountainous terrain and water resources makes hydro a key pillar of Italy's energy mix."